The Fed and the Secular Decline in Interest Rates

Abstract

In this paper I document a striking fact: a narrow window around Fed meetings fully captures the secular decline in U.S. Treasury yields since 1980. By contrast, yield movements outside this window are transitory and wash out over time. This is surprising because the forces behind the secular decline are thought to be independent of monetary policy. However, it is possible that the bond market learns about these forces from the Fed. Two additional facts support this interpretation: (i) long-term yields drop immediately following Fed announcements, and (ii) the Fed’s expectation about the long-run level of the federal funds rate – revealed through the dot plot – has a strong impact on long-term yields. To explain these facts, I present a dynamic term structure model in which the Fed learns from the yield curve and the market learns from Fed meetings. The model rules out alternative explanations such as business cycle information and risk premia. It further implies that the Fed possesses important information about the long-run neutral interest rate. This can explain why Fed announcements have a powerful impact on the valuations of long-lived assets like the stock market.